Last Updated on December 17, 2022 by Anda Malescu
For a potential business buyer or seller, it is very important that he or she obtains a realistic business valuation prior to any deal or even starting negotiations for a deal. There are three main approaches to valuing a company that is recognized by both regulators and practitioners. These include the asset-based valuation approach, the income-based valuation approach and the market-based valuation approach.
The asset-based valuation approach takes the notion that a company is worth its assets less its liabilities
Depending on the situation, a company can be valued as going concern or in liquidation. Going concern means that the company is assumed to continue operations in the foreseeable future (usually at least a year) under a prudent management. When a company is valued in liquidation it means all assets of the company are expected to be sold to satisfy creditors and that operations cannot continue due to the lack of funds. When a company is valued as going concern all assets on the balance sheet are restated from historic cost less depreciation to fair market value. The same is true for the company’s liabilities.
For revaluing hard assets, a business valuation professional can use appraisers or examine the prices of similar equipment at a similar age. Intangible assets are bit harder to value but there are widely accepted methods that can produce a reliable figure for their value.
When a company in liquidation is valued using the asset-based approach, its assets are adjusted to net-realizable value assuming a distressed sale of the assets. This method would produce significantly lower values then if the company was valued as going concern, but that is fair given that the assets must be disposed in short-order.
The income-based valuation approach takes into account the rate of return a prudent investor would require given the same level of risk as the valued company
That required rate of return is know as a discount rate or capitalization rate. The most common valuation methods that use the income-based approach are the discounted future cash flows method and capitalization of earnings method.
First, in order to determine the appropriate discount/capitalization rate, a business valuation professional would take into account the risk-free rate, usually the least risky government bond in the respective country, add the market risk premium, or how much extra return an investor would demand to invest in the stock market. Other add-ons include an industry risk premium, a size-premium for smaller companies and premium for market companies.
Once the proper discount rate is chosen, the valuation professional would proceed to choose either the discounted future cash flow method or the capitalization of earnings method. The capitalization of earnings method assumes the current earnings of a company would continue indefinitely. Sometimes, earnings are adjusted for the owner’s salary and other benefits in the case of small businesses.
Once the earnings are determined, they are divided by the capitalization rate to determine the final value. The discounted future cash flow method relies on projecting the future cash flows of the business and then discounting them to present value, using the appropriate discount rate. This method often assumes a two-stage growth rate with a higher growth rate initially and then a lower growth rate that continues indefinitely. This method is more suitable for growth companies that can see accelerated growth in the immediate future while the capitalization of earnings method is more suitable for mature companies that produce consistent cash flows.
The third and most reliable valuation approach is the market-based approach. It includes the comparable transactions method and the market multiple approach
Under the comparable transactions method, a valuation professional first identifies companies that are similar to the one being valued and that have also been subject to a purchase or sale in a relevant time period. Based on the transacted price the valuation professional would calculate ratios such price/earning or price/cash flow and would apply those ratios to the valued company to determine its worth.
The market multiple approach is like the comparable transactions method in that it uses the same ratios, but instead of identifying companies that were subject to mergers or acquisitions, the valuation professional would use comparable companies that are publicly traded. That method assumes that the stock market provides a reliable valuation of the comparable company.
All the valuation methods above are acceptable and widely used. A valuation professional usually uses all three approaches and selects the business valuation methods most suitable for the valued company given its growth stage, predictability of cash flows, business model and availability of reliable data. All business valuation methods require a great deal of assumptions and professional judgment to be applied. Therefore, it is important to hire an experienced and certified valuation professional to produce a reliable estimate of your company’s value.
Our business lawyers in Miami, Florida USA can assist our clients in retaining a certified valuation professional. Contact us today!
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